Credible Losers: A Regulatory Design for Prudential Market Discipline

Abstract

Those who lend money typically take steps to protect against or compensate themselves for the risk the borrower will default. These steps — such as charging higher rates of interest for riskier loans — can affect borrowers’ activities in salutary ways. Lenders thus “discipline” borrowers to rein in risk. This type of market discipline can be an important supplement to regulatory efforts to ensure that banks and other financial firms do not take imprudent risks that wind up costing taxpayers or destabilizing the financial system. For lenders to serve as disciplinarians, however, they must expect to bear losses if the borrower becomes insolvent. If lenders believe the government will “bail out” an insolvent borrower, they will not expect to bear losses, and will have little incentive to monitor or discipline the borrower. Because of this, market discipline of the largest financial firms, where bailout expectations persist, is broken. It is not enough for regulators to say that they will impose losses on some class of creditors to reset the creditors’ expectations: such promises must be credible. I refer in this Article to lenders who expect to bear losses in the event of default as “credible losers.” Establishing credible losers among the claimants on systemically important financial institutions poses a knotty challenge. This Article offers a framework for meeting this challenge by articulating three criteria for establishing credible losers in support of prudential aims. It then applies the framework to evaluate a new proposed rule that largely meets these criteria for the largest financial institutions in the United States. The proposed rule can be understood to require these firms to issue a type of debt that converts to equity upon the failure and resolution of the firm. The Article then points to gaps in the rule’s coverage and proposes two possible ways to fill these gaps. First, debt that converts to equity prior to insolvency or resolution may help create market discipline for financial behemoths to which the rule does not apply. Although a European experiment with such “contingent convertible” (CoCo) debt has been problematic, the disciplinary role of such instruments may be strengthened by improving their design and clarifying their regulatory treatment. Second, “side bets” — in the form of credit default swaps or prediction markets — may help establish “credible losers” where the rule fails to do so.